Major Index Performance
Well, well, well, after underperforming for most of the year, small-cap stocks (i.e., the Russell 2000) came into their own as the best performing major equity segment in Q3. This was due to better-than-expected domestic economic developments - particularly GDP growth, consumer spending, and inflation - and falling interest rates across the board. Since small-cap stocks receive less revenues internationally, when there is positive news domestically, small-caps typically perform well relative to their more internationally diversified large-cap counterparts. The same can be said for the Dow Jones, with the “older economy” index coming in as the second-best performing index in the cohort.
The growth heavy Nasdaq finished at the bottom of the pack but still generated a positive return. This was due to the highly valued index taking a breather from its breakneck performance from the first two quarters. Positive sentiment was held in check as the market re-assessed its growth expectations for the rest of the year and beyond. Finally, the S&P 500, which has a blend of older Dow Jones and newer Nasdaq style stocks, finished in the middle, returning 5.89%.
To round it out, the Emerging Markets and EAFE indices returned 8.72% and 7.26% respectively.
U.S. Sector Performance
An unexpected, boring sector was the best performer in Q3, Utilities. However, when we dig into the fundamental reasons for why it begins to make sense. One, utility companies are highly levered, so interest rates falling help these companies with their debt burdens and overall cost of capital. Two, since a lot of these companies are seen as high-income value stocks, when interest rates fall, their dividends look more attractive to market participants relative to fixed income securities. Simply put, this makes risky dividends look better than the risk-free bond alternative. Finally, many utility companies are receiving a boost in business demand due to the amount of electricity required to run emerging AI technologies. This development improves company earnings which subsequently improves company stock prices.
All of these reasons boosted the demand for these steady eddy payers, sending the Utilities sector upwards in Q3.
The same goes for Real Estate, albeit to a lesser extent, which was the second-best performing sector. In addition to the reasons why Utilities performed well, sans the electricity demand reason, Real Estate has been heavily beaten down by fears of prior years’ overbuilding and overvaluation. So it’s likely that market participants are re-evaluating their doom and gloom predictions and concluding that it’s not as bad as they previous thought.
At the bottom we have the Energy sector, which can be entirely explained away from poor commodity pricing. WTI crude and natural gas prices fell 11.73% and 6.53% respectively. Obviously when what you’re selling falls in price, that’s going to impact company profitability and therefore company value.
The Tech sector was the second worst performing sector, posting a flat 0.03%. As mentioned previously when discussing the Nasdaq, the Tech sector likely took a breather after rallying significantly for the first half of the year, allowing earnings to catch up to valuations.
S&P 500 Top/Bottom Performers
Year to Date
Second Quarter
Erie Indemnity Co (ERIE) – Passive Flows Drive Performance of This Boring Company
Erie Indemnity company is a Plain Jane property and casualty insurance company headquartered in the northeast. Who said you have to be an AI stock to perform well?
Their momentum stems from two factors. One, a blowout Q2 earnings report in which they reported $3.17 in earnings per share (EPS) versus an expected $2.55. The second, and more important factor was the announcement that their stock would be included in the S&P 500. While this seems like an odd reason to justify its high-flying performance, keep in mind that passively managed index funds now have to buy ERIE to accurately reflect their S&P 500 following mandate. So, a MASSIVE amount of money flowed into the stock boosting its share price.
Palantir’s inclusion into the S&P 500 and subsequent rise benefited from this reason as well as it returned 46.86% for the quarter. Of note, Palantir is a big data/AI company backed by legendary venture capitalist Peter Thiel.
GE Vernova Inc (GEV) – It’s Electric!
As mentioned in last quarter’s commentary, power generation stocks are going to benefit from the increased need of electricity to run AI data centers. Unsurprisingly, GE Vernova Inc. was a beneficiary of this rise in electricity demand. In addition, they provide green energy options for customers, which is looked on favorably by major corporate tech buyers, many of whom have mandates that require a portion of their power comes from clean energy sources. Google is one example of a company with this mandate. In addition, analysts upgraded the stock on these positive developments, increasing the sentiment for GEV and other stocks in the power generation sector.
Super Mico Computer Inc (SMCI) – If Icarus Had Accounting Issues
Yikes! After being one of the best performers for the year, Super Mico Computer Inc, got nearly chopped in half in Q3. The primary reason is that SMCI has had accounting issues which Hindenburg, a short selling investment company, pointed out. Hindenburg’s report caused SMCI to delay their filing after they pointed out some glaring accounting red-flags. If Hindenburg’s history is any guide, SMCI is in trouble. To illustrate, they issued a negative report on Nikola, a clean energy big-rig start-up, and since then the stock is down 99% with their founder Trevor Milton is in jail for four years due to securities and wire fraud.
All of that to say, you don’t want to be in Hindenburg’s crosshairs. Like the blimp from which their firm is named after, when they write a report on your stock, it’s likely to blow up in spectacular fashion.
International Indices
Developed Markets
Australia was the best performing international developed country returning 10.97% in Q3, this can be mostly attributable to positive economic developments in the country as their financial sector was the strongest performing sector in Q3. This points to an increase in expected economic activity in the country, as banks and other financial institutions primarily make their money from lending money to other businesses and institutions. In addition, positive commodity performance provided a tailwind as well as Zinc and Aluminum rose 5.02% and 3.80% respectively.
Japan on the other hand was the worst performing international developed country, “only” appreciating 4.84% for the quarter. Japan has been grappling with interest rate issues and carry traders. A “carry trade” is when you borrow from a low-interest rate country and then use the proceeds to invest in a high-interest rate country. These traders make money by capturing the spread between the two interest rates. So, hypothetically, if you could borrow at 1% and buy into a bond yielding 4%, you’d return 3%. Because of the small returns, carry traders often significantly leverage their positions to generate higher returns.
To illustrate the issue, Japan’s markets would fall a cumulative 16.97% following the Bank of Japan’s announcement that they were going to raise rates on July 31st. Since many traders were borrowing in Japan and investing elsewhere, this caused some panic as the interest rate they were borrowing from increased, causing the trade’s profitability to fall. Add that many of these positions were leveraged and that further adds fuel to the fire.
However, Japanese stock markets would go on to recover, appreciating around 20.00% from that point.
Emerging Markets
China was the best performing country in the emerging market index. China has been beaten down for so long that any positive corporate or economic news spurring a rally was inevitable. It’s sort of like when your bum family member or friend does something unexpectedly positive to improve their life and you’re proud of them and hopeful for their future trajectory. Well, China is the current bum markets have counted out, so when they finally showed some signs of improvement, markets cheered and rewarded their companies’ share prices accordingly. However, concerns of escalatory U.S.-China tit for tat should be top of mind for investors who are thinking of investing in Chinese stocks.
China’s major tech companies, Tencent and Alibaba, which can be thought of as the United State’s Facebook (now Meta) and Amazon, rallied significantly in Q3, returning 47.39% and 16.98% respectively. Since these two companies make up approximately 25.00% of their index, their performance will drive a material portion of China’s gains and losses.
On the other end of the spectrum, our friends in the south, Mexico, didn’t fare too well. This was likely due to ongoing concerns regarding a far-left party gaining control of the government and the uncertainty that surrounds this development. Since markets don’t like uncertainty, capital flowed out of the country, causing continued underperformance. This political development was discussed extensively in the last quarter’s commentary.
U.S. Fixed Income
U.S. Yield Curve
Yields fell across the curve, which is unsurprising given the Fed cut bigger than what was previously anticipated. The markets priced in a 25bps point cut, but the Fed delivered a 50bps cut. While this on the face of it is positive for economic growth, the underlying motivation for the rate cut is uncertain. Was it done because we’re out of the persistently high inflationary environment or because labor markets are starting to deteriorate? One is positive for the future of stock markets, the other is much more concerning.
Credit Curve
Because of the rate cut and positive economic developments in Q2 and Q3, credit spreads generally fell across the curve, with speculative CCC or below falling the most. The thing that makes speculative debt interesting is that it is sensitive to both interest rate expectations and economic developments. This is unlike highly rated debt that is almost solely driven by interest rate expectations. Since companies with speculative grade debt are poorly performing and highly indebted, they’ll perform well when rates are falling. This is because of their heavy interest burdens and an improving economy increases the demand for their services. Both of which decreases the perceived riskiness of these distressed businesses and subsequently decreases their credit spread (i.e., the extra return required to lend these companies money).
To summarize, interest rates and credit spreads fell, so securities highly sensitive to interest rates and credit conditions performed the best. So perhaps unsurprisingly, the Vanguard Extended Duration Treasury fund performed the best, returning 9.73% whereas the Schwab Value Advantage Money Market fund performed the worst, only returning 1.27%. However, due to falling interest rates and credit spreads, there were no negative performing fixed income segments in Q3.
U.S. Economy
Real GPD grew at an 0.74% rate in Q2, which annualizes to 2.96%. This is roughly in line with it’s year-over-year growth and long-term expectations for growth in general. The largest contributor to growth was from the second largest GDP component which is private domestic investment (think companies spending money to build factories and other long-term assets), which grew an astounding 2.02% for the quarter. The increase in businesses willingness to invest was likely due to the previously high inflationary environment ending, giving businesses a more certain environment from which to make investment decisions.
As alluded to earlier when discussing rate cuts, the labor market is starting to show concerning cracks. The unemployment rate increased to 4.20%, which is above 3.80% from a year ago. An increase in unemployment is typically associated with a recessionary environment, as less people with jobs leads to less income to spend on goods and services, so this development is a little concerning given that markets are near all-time highs.
Unsurprisingly, given unemployment has increased, job creation slowing and an increase in claims for unemployment insurance aren’t a shocker.
Personal income is also slowing, although median pay is accelerating. This could be pointing to the fact that highly compensated employees aren’t receiving the pay increases that they enjoyed in previous quarters whereas your average person is. This makes sense, since a lot of the large finance and technology companies have announced layoffs, likely from overstaffing during the Covid lockdown period.
However, price growth is slowing, although it’s slowing at a rate that is below the Feds target of 2.00-2.50% when annualizing the most recent three month’s readings. This makes sense given the labor market slowing. When there are less dollars chasing goods and services, prices should slow. Simple supply and demand dynamics at work.
To round it out, the real estate market still looks wonky. It looks like buyers prefer new builds relative to existing home sales, which may point to the realism in new builders’ home pricing versus the price that existing home buyers are anchored to. People are hesitant to sell below the top price that their property was worth or the price that they purchased their home at, hence this anchoring bias. But, if existing home buyers don’t have realistic expectations for what their house is worth, home buyers will simply opt for the new builds or the “upgraded model” relative to a house that’s been around for a while. Why pay for a “used” model when it’s priced around what a “new” model is going for?
Looking Forward
The Unexpected Large Rate Cut. What’s That Signal?
Alluded to earlier, the unexpectedly large rate cut that was made in September left market participants a little off kilter.
The motivation for the rate cut is what matters. Is it because the inflationary fight is over or because persistently high rates are starting to take their toll on the economy? Well, the answer is both. Inflation is falling but unemployment is rising and job creation is slowing.
Jerome Powell has stated that they are taking a month-by-month look at economic numbers when making interest rate decisions. So looking forward, markets will be very sensitive to economic numbers that come out between now and the end of the year, especially labor market readings. If labor markets start showing distressing signals, expect larger rate cuts. If not, then expect slow and steady 0.25% rate cuts. If prices begin to accelerate, expect no rate cuts or possibly rates rising.
The worst-case scenario is if we see inflation start to pick up again with unemployment also rising meaningfully. This would put the Fed in a pickle as it tries to navigate a stagflation environment (i.e., a high unemployment, high inflation environment). Under this scenario, the market, like the Fed, will have to navigate a highly uncertain environment which could cause a selloff as participants rush to cash. However, I believe this case to be the least likely of all discussed but I am watching the economic reports and listening to the discussions around the economy closely.
Q3 2024 Earnings. Mostly AI But with Overlayed Economic Concerns
What to look forward to in Q3? AI of course! These stocks are still richly valued, however it’s much less of a concern than last quarter, as the sector’s performance was mostly muted, allowing earnings to come in and valuations to normalize.
What’s going to be much more interesting in Q3 earnings are the earnings reports for companies that are sensitive to underlying economic activity. Sectors to be on the lookout for are the industrials, materials, and financial industries. The major banks start reporting the week of October 7th, which could set the scene for the rest of the quarter and beyond. Also, tune into what the C-suite of these major banks say about economic conditions. They would know how the underlying economy is performing better than most.
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